Cash Flow Coverage Ratio

The cash flow coverage ratio is the ratio of operating cash flow to its debt. It is used to understand whether the company is capable of paying its debts from its income from operations or not. It is useful to investors, banks, creditors and the management of the company itself for self-evaluation.

Businesses need cash flow to cover its expenses and pay off its liabilities. Whether it is a big firm or an SME, cash flows are a very important aspect of every business entity. The cash flow coverage ratio is a liquidity ratio that helps to understand the position of the cash in a business and whether that is sufficient or not to pay off the debts and the expenses of the businesses or not. Every business has some current liabilities which it has to meet and thus require money which is the cash flow generated from the operations. If a company cannot pay off its current expenses and obligations, it is either not utilizing its resources fully or there is inefficiency in the uses of the resources. Thus cash flows fall short of the obligations it has. It is a measure of liquidity of the business at current times that is whether it can pay off the mandatory expenses like rent, interests, preference dividends etc. or not.

What is a Cash Flow Coverage Ratio?

Cash Flow Coverage Ratio

The cash flow coverage ratio can be defined as the measure or indicator of a company’s or business’s capability to fund its own current expenses. This ratio indicates whether the cash generated from the main operation of the business is enough or not to pay off its mandatory expenses (current obligations). The operating cash flow is the amount which is obtained by the business with its primary products or services. The simple cash flow coverage ratio analysis says that anything more than one is a good ratio as that indicates the company’s fund is more than its current liabilities. But a ratio less than one indicates that the company is having less fund than the required sum for paying off its liabilities, it might have to consider a refinancing or restructuring the operations to generate more cash flows.

Calculation and Formula of Cash Flow Coverage Ratio

The basic formula for calculation is as follows:

Cash Flow Coverage Ratio = Operating Cash Flows / Total Debts

But there are different versions of the ratio which are actually used in financial calculations to deal with different types of debts.

  1. Short-term Debt Coverage Ratio = Operating Cash Flows / Short-term debt
  2. Dividend Coverage Ratio = Operating Cash Flows / Cash Dividends
  3. Capital Expenditure Coverage Ratio = Operating Cash Flows / Capital Expenditures
  4. CAPEX+ Cash Dividends Coverage Ratio = Operating Cash flows / (Capital Expenditures + Cash Dividends)

Examples of Cash Flow Coverage Ratio

Let us assume, a Co. has a short-term debt of USD 100000, Cash dividends to be paid of USD 50000, Capital Expenditure of USD 500000 and the operating cash flow for the year is USD 900000.

Then,

Short-term Debt Coverage Ratio = Operating Cash Flows / Short-term debt = 900000/100000 = 9

Dividend Coverage Ratio = Operating Cash Flows / Cash Dividends = 900000/50000 = 18

Capital Expenditure Coverage Ratio = Operating Cash Flows / Capital Expenditures = 900000/50000 = 1.8

CAPEX+ Cash Dividends coverage Ratio

= Operating Cash flows / (Capital Expenditures + Cash Dividends)

= 900000/ (500000+50000) = 900000/550000 = 1.64

Cash Flow Coverage Ratio

= Operating Cash Flows / Total Debt

= 900000/ (100000+50000+500000) = 900000/650000 =1.38

Analysis of Cash Flow Coverage Ratio

The analysis of cash flow coverage ratio is the main motive behind finding these ratios. Here, in the above example, all the ratios are more than one which depicts that the company is having the good cash flow to pay its debt. But if we dig a little deeper we would find, that Johnson & Co. may be very good in paying off its short-term debts as the short-term debt ratio is 9 which means its operating cash flow is nine times more than its short-term debt amount. But when we see the capital expenditure coverage ratio, it is only 1.8 times but that is still fine. Then we come to cash flow coverage ratio which is 1.38 times which means the operating cash flow is only 1.38 times of the total debt of the company. In the stable business cycle, this might not be a sign of a problem, but in case of turmoil in the business, then the company can pay its short-term debt easily but might find it difficult to pay the long-term ones.

Uses of Cash Flow Coverage Ratio

The importance of cash flow coverage ratio is different to different people.

Management of a Company

For the internal members of the business entity like the managing director or the CEO, it is a metric to understand whether they are in a good position to pay off their liabilities or not.

Banks

For the banks which will sanction loan to the company calculates this ratio to find out the credibility of the business entity and the risk associated with repayment.

Investors

For the investors, it is the dividend factor which plays in the mind that whether they will be paid the dividend on time or not and for the creditors, again whether their debt will be paid off on time or not and if there is a crisis what can be the scenario.

Shareholders

The shareholders also calculate this ratio for cash dividend payments as they are the last on the checklist when business liquidates. If they find that the ratio is high, then the company might distribute more dividends to the shareholders as well.

When this ratio is implemented with other financial calculations it gives insights of the company’s earning and how the earnings are utilized and a lot of other facts and aspects.

Conclusion

The cash flow coverage ratio thus helps in understanding the ability of the company to pay off its debts whether short-term or total debt and even the dividend payments. It gives the investors, creditors and financial institution the insight of the company’s earning and whether the resources are optimally utilized or not to generate operating cash flow at its best.

Resources:

https://www.myaccountingcourse.com/financial-ratios/cash-flow-coverage-ratio

https://www.investopedia.com/university/ratios/cash-flow-indicator/ratio3.asp

https://www.readyratios.com/reference/cashflow/cash_flow_coverage_ratio.html

Last updated on : February 15th, 2018

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2 Comments

  1. JOSE LUIZ VALIM

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